• Stocks headed into the second half with impressive momentum. Historically, a strong first half tended toward above-average second-half returns.
• Market gains were heavily skewed towards the large-cap growth and technology companies. The S&P 500 became increasingly concentrated in, with just five companies accounting for 29% of the index.
• Economic growth moderated but remained resilient with signs of cooling in the labor market along with lower inflation.

Market Summary

U.S. large-cap stocks, as measured by the S&P 500, extended their strong momentum and rose for the third successive quarter. The S&P 500 reached new all-time highs during the quarter as investors were encouraged by better-than-expected earnings growth, a resilient economy, improving inflation indicators, and renewed expectations for interest rate cuts this year.

Many of the same themes from the past twelve months continued during the quarter. Market gains were concentrated among the largest companies in the information technology and communications sectors, which were expected to benefit from artificial intelligence developments. For example, NVIDIA, the largest semiconductor company by market cap, rose 37% during the second quarter, accounting for 44% of the S&P 500’s quarterly performance. Apple, Alphabet, and Microsoft also contributed significantly. The S&P 500 would have posted a negative return for the quarter without these four companies (1).

In areas outside of US large growth, stocks struggled to keep pace. This market dynamic wasn’t new. Except for 2022, when US large growth stocks lost 29% versus just 7.5% for large value stocks, large growth has beaten large value every year since 2017 (2). Similar results apply to US large-cap versus US small-cap stocks and US large-cap vs non-US stocks. This outsized performance by a few large companies increased the S&P 500’s market concentration: the largest five companies accounted for a record 29% of the S&P 500, nearly double the 25-year average weight of 15%. It has also turned the S&P 500 into a large growth index per Morningstar data. Before this year, it had always been classified as a blend.

For high-priced growth stocks to continue outperforming, they must either maintain their impressive earnings growth rates long into the future or maintain their high relative valuation ratios. If these businesses can sustain their advantage for longer than businesses have in past technology transformations, they may continue to outperform. However, if this cycle of growth dominance is like past cycles, lagging areas of the market may play catch-up in the years ahead.
Recent economic data was weaker than consensus expectations and favored the Fed to cut rates from restrictive levels. Inflation continued to progress lower, and the labor market cooled somewhat from the tight conditions after COVID. Despite other central banks cutting rates, namely the European Central Bank and Bank of Canada, the Fed kept rates steady in the quarter, defying market expectations for several rate cuts entering this year. By the end of the quarter, markets were expecting two rate cuts through the end of 2024.

The Bloomberg U.S. Agg Bond Index was roughly flat as income earned offset the price declines from rising longer-term rates. Credit-sensitive sectors did better than high-quality sectors, and shorter maturities did better than longer maturities. Below is a summary of the benchmark returns. (3)

Markets: High concentration led to most stocks underperforming the S&P 500

Longer-term stock market trends remained favorable. Above-average second-half returns have historically followed strong first halves. In addition, S&P 500 companies were expected to grow earnings at double-digit rates in the upcoming quarter. Easing inflation pressures pointed to a potential rate cut from the Fed later this year, which could help the rally broaden out into other areas of the market.

The bad news was that most stocks didn’t keep up with the S&P 500. For example, the median S&P 500 stock was up just over 3% year-to-date, and only 25% of S&P 500 stocks outperformed the index, which, if the year ended June 30th, would be a record low dating back fifty years (see graph below) (4).

The 25 largest companies, which comprise nearly 50% of the S&P 500, increased by 27% in the first half. The rest of the S&P 500 increased only 6% (5). This narrow breadth could be attributed to higher interest rates (many of the largest stocks aren’t as interest rate-sensitive), the AI theme benefitting the largest companies, and a bifurcated earnings backdrop where the mega caps saw significant earnings momentum.

Very few historical analogs exist to this type of market behavior, and most showed an increased risk of a drawdown in the coming quarter. Importantly, something bad doesn’t necessarily have to happen, and it does not change our estimation of the longer-term positive trend in stocks.

Economic: Slowing but growing

The economy wasn’t much different than at the start of the year, but it did appear to worsen on the margin. U.S. GDP growth slowed to 1.4% annualized in 1Q, down from 4.9% in Q3 2023, and 3.4% in Q4 2023. Meanwhile, core inflation continued to ease, falling from 3.8% in March to 3.3% in June, and the unemployment rate rose to 4.1% from a low of 3.4% in April 2023. The unemployment rate was still near a 50-year low, but it was also the highest level since November 2021.

The question was whether the recent unemployment data was simply a continuation of the relatively painless moderation of the past few years or the beginning of something more damaging. So far, the unemployment data was still consistent with a growing economy, but it has increased our attention toward the rising risks of a recession.

Data contributing to a positive economic backdrop included strong household balance sheets. Household net worth was at all-time highs, and debt service ratios remained historically low. Consumer confidence indicators recovered as inflation continued to fall, and wages grew faster than inflation, supporting consumer spending.

Inflation peaked in mid-2022 at 9.1% and has been coming down since. The aggregate price levels are roughly 20% higher than in the pre-pandemic period (red line in graph). Still, it is important to note that wages and nominal income were also roughly 20% higher (blue line). Importantly, real income to consumers was higher (green line) (6).

Further, inflation was declining globally, and many other central banks, such as the European Central Bank and the Bank of Canada, were already lowering rates.

We continue to monitor risks, including an inverted yield curve with a strong history of forecasting economic downturns and the Federal Reserve’s interest rate-raising campaign, which has almost always precipitated a recession. The yield curve has been inverted for 19 months, which is longer than the average time it takes from the date the inversion first started to the onset of a recession (see graph) (7).

In addition, fiscal spending, which offset much of the drag of the Fed tightening cycle, started to contract year over year.

Portfolio Positioning

We still see a fundamental backdrop for equities. U.S. inflation continued to ease, short-term rates were likely to come down, and economic growth remained positive. In addition, corporate earnings growth grew and was expected to accelerate further in the back half of 2024.

Technical indicators also continued to be positive for stocks, suggesting they could continue to rally into year-end. At the same time, a pullback wouldn’t be surprising given overly optimistic investor sentiment, the concentrated nature of the market rally year-to-date, and the fact that market volatility generally increases in the months leading up to an election.

2023 and so far in 2024 have made diversification away from US large-cap stocks look foolish. This strong performance has forced us to review the potential benefits of allocating to other asset classes. Our conclusion is simple: diversification is essential, especially in periods of high valuations and fear of missing out on the next big thing.

Diversification gives us different tools for different jobs. Times like now, the US large cap “tool” is working well, but there will be a time that we will need a different tool for the job. When one tool appears to be all you need, adding other tools to your toolbox is even more important. We continue to see attractive opportunities outside of US large-cap equities.

We remained overweight stocks during the quarter. We still like undervalued parts of the market—such as exposure to US large value and US midcap—and are overweight US equities vs. non-US equities.

Turning to bonds, a new regime of positive correlations between stocks and bonds suggests that higher interest rates have the power to “break” things on the equity side. As a result, we remained overweight shorter-term bonds. Short-term bonds have been a better ballast during uncertain or “risk-off” markets the last three years, and we are not getting paid much more interest to take on longer maturity bonds.

Not all portfolios are identical. We manage accounts with additional complexities not discussed in this update. Some of the statements are forward-looking but do not guarantee future performance. Please reach out to your advisor with any questions.

Footnotes:

1. Morningstar Direct
2. Russell 1000 Growth TR, Russell 1000 Value TR. Data from Morningstar Direct
3. Morningstar Direct, as of 6/30/2024
4. Ned Davis Research
5. Data from Morningstar
6. Federal Reserve Economic Data
7. Ycharts